Financial System Report (April 2013)

Overview

The external environment surrounding Japan's financial system

Regarding the external environment surrounding Japan's financial system, some signs of improvement have been observed, but uncertainty about the future is still high.

In global financial markets, investors' risk aversion has gradually abated. As for the real economy, the U.S. economy has been on a moderate recovery trend, and the Chinese economy has shown signs of picking up. Nevertheless, many problems remain to be resolved for the fundamental resolution of the European debt problem.

Japan's economy remained relatively weak from the second half of 2012, but has recently stopped weakening and shown some signs of picking up. In this situation, firms have been taking a cautious stance in financing, and firms' financial conditions have generally improved. However, some small and medium-sized firms have continued to face severe financial conditions, and principal and interest repayments relative to income for households with housing loans remain generally large. In the public sector, government debt has accumulated, with a continuing fiscal deficit.

Financial institutions' performance of financial intermediation

Financial conditions of firms and households in Japan are accommodative. Issuing conditions for CP and corporate bonds have remained favorable on the whole. Banks' domestic loans outstanding have increased, particularly for working capital and funds related to mergers and acquisitions. Major banks have increased overseas loans, and some regional financial institutions have enhanced their initiatives to support overseas business expansions of small and medium-sized firms in their local areas. However, growth in the amount of investments and loans to start-ups has been weak.

Risks in the financial system

Judging from the results of the examination of indicators of macro financial risk, thus far there is no indication that warns of financial imbalances stemming from bullish expectations. Due attention should be paid, however, to the fact that the amount outstanding of Japanese government bonds (JGBs) held by financial institutions remains large. Moreover, although the amount of risks borne by banks and shinkin banks has been decreasing relative to capital, their core profitability has declined.

Resilience of the financial system

The macro stress testing shows that the resilience of Japan's financial system is generally strong as a whole. Banks' capital bases as a whole would be able to avoid significant impairment, even if a significant negative shock occurred such as the economic downturn similar to that observed after the Lehman shock. Nevertheless, capital adequacy ratios may plunge at banks whose core profitability or quality of loans is low. It appears that banks as a whole hold a sufficient amount of funding liquidity both in the domestic and foreign currencies.

Challenges to ensure stability of the financial system

Japan's financial system as a whole has been maintaining stability. However, in order for financial institutions to maintain smooth financial intermediation, they need to address the following major management challenges.

First, financial institutions need to raise their profitability. It is important for financial institutions to tap potential demand for financial services by enhancing the effectiveness of their support for client firms that are reconstructing their business or that are engaged in growing business areas. They can enhance the effectiveness of such support by, for example, strengthening their expertise to identify projects' growth potential and risks or devising ways to effectively utilize a range of financial instruments. In addition, one potential option for financial institutions seeking to raise their profitability is to improve their business efficiency or expand their customer networks through mergers.

Second, financial institutions need to strengthen their capital bases. It is indispensable for them to enhance their capital to continue financial intermediation in areas with high risk and return through investments and loans to growing business areas at home and abroad.

Third, financial institutions need to continue to enhance the effectiveness of risk management. Given the recent increase in the extension of overseas loans and large-lot loans, it is vital for financial institutions to restrain concentration risk associated with loan portfolios at home and abroad and strengthen their risk management of large-lot loans, as well as to work further to support firms' reconstruction. It is also important for them to grasp a range of risks associated with bondholdings. In addition, they need to continue to manage market risk associated with stockholdings appropriately, taking into account the effects of developments in stock prices on, for example, their profits.

Notice

This Report basically uses data available as of March 31, 2013.

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Inquiries

Financial System Research Division, Financial System and Bank Examination Department